1. Effects
of
infla.on
targe.ng
misfiring
on
development
of
housing
market
bubble
and
its
burs.ng
in
2008
credit
crisis
Author:
George
Perendia,
LMBS
e-­‐mail:
george@perendia.orangehome.co.uk

2. Background:
 The
so
called
"years
of
great
modera.on",
the
years
of
rela4vely
stable
and
low
infla4on
since
early
1980,
 a
period
of
reduc4on
in
government
spending
and
 period
of
the
new
infla4on
targe4ng
mechanism
providing
 stable
and
– low
infla4on
(2%)
and
– low
interest
rates,

3. Background:
 They were all but that!
 in the long term, low
interest rates were a
green light for many:
– the consumers,
– the households,
– the investors, and
– the governments,
to start borrowing
excessively with
expectation of ever
low repay interest
rates!

4. Background:
 The more the households
borrowed,
 the more they would consume
 creating higher demand, and,
 the resulting higher GDP output
 enabled governments to borrow
and spend even more.
 The low inflation was supported
by import of cheaper goods from
developing countries, and
 the trade deficit was balanced
by government debt being sold
to the same, mainly exporting
countries of East Asia
 whose foreign reserves
rocketed since 2002.

5. Crisis
at
The
Gate:
 Many authors, in particular from
IMF background, argue that
 increase in public debt
 reduces prospects of growth
mainly due to the pattern of
resulting under-investment
caused by the investor
expectation of higher:
– long-term interest rates,
– future taxation,
– inflation and
– economic volatility
 see e.g. Kumar M.S. and Woo, J
2010: Public Debt and Growth1,
IMF Working Paper, July 2010.

6. Crisis
at
The
Gate:
 As few authors show, in some
cases increased debt may be
beneficial for growth.
 Traum and Yang (2009) show
that if increased government
debt was used to
– reduce capital gains taxes or
– for business investment,
then further investment can be
 attracted (I.e. crowded-in)
 instead of being discouraged
(and crowded-out),
 leading to increase of GDP
 see: Nora Traum And Shu-Chun S.
Yang (2009): Does Government
Debt Crowd Out Investment? A
Bayesian Dsge Approach;

7. Crisis
and
the
Bubble
Burst:
Infla.on
mis-­‐targe.ng
 in spite of the rising inflation in
2003 and 2004,
 the federal funds target rate
was lowered even further from
2002 to 2004 (left) and
 the resulting, “real” fed. funds
target rate (lower left), i.e. the
rfft – π (inflation) was actually
around 2.5% below 0 in Q1 of
2004!
 then it rose, from Q2 of 2004,
to nearly +3.5% by Q4 of 2006
and
 stayed rather high throughout
2007.

8. Crisis
and
the
Bubble
Burst:
Infla.on
mis-­‐targe.ng
 Few authors showed that
lowering of federal funds target
rate from
– 6.5% in 2000 to a
– mere 1% by mid 2003
may have accelerated both
– the industrial and
– the private housing investment
and the sale of both:
– the prime and
– the sub-prime mortgages
see e.g.: Dokko, J., Doyle, B., Kiley, M.
T., Kim, J., Sherlund, S., Sim, J., and
Van den Heuvel, S.: Monetary Policy
and the Housing Bubble,; Finance and
Economics Discussion Series Divisions
of Research & Statistics and Monetary
Affairs Federal Reserve Board,
Washington, D.C. 2009

9. Crisis
and
the
Bubble
Burst:
Infla.on
mis-­‐targe.ng
 Whilst US Fed (and Mr B.
Bernanke) reject that FED
facilitated the housing bubble
 in contrast, J.B.Taylor (2007)
indicated that such “too loose”
monetary policy during
2003-2004 period probably
lead to the extensive housing
activity.
 See: Taylor, John B. (2007).
Housing and Monetary Policy,
NBER Working Paper Series
13682.Cambridge, Mass.:
National Bureau of Economic
Research, December 2007.

10. Crisis
and
the
Bubble
Burst:
Infla.on
mis-­‐targe.ng
 Gordon (2009) also points to
many similarities between
1927-29 and the 2003-06
bubbles, from
– highly leveraged (90%), low
interest loans for stock and
housing purposes
respectively, to
– the regulatory failures caused
by repeal of Glass-Steagall
Act.
 see: Gordon,R. J. (2009). Is
Modern Macro or 1978 Era Macro
More Relevant to the
Understanding of the Current
Economic Crisis? Northwestern
University, September12, 2009

11. Crisis
and
the
Bubble
Burst:
Infla.on
mis-­‐targe.ng
 They however note:
 …“It is widely acknowledged
that the Fed maintained short
term interest rates too low for
too long in 2003 04, in the
sense that any set of
parameters on a Taylor Rule
type function responding to
inflation and the output gap
predicts substantially higher
short term interest rates during
this period than actually
occurred… thus indirectly the
Fed’s interest rate policies
contributed to the housing
bubble”

12. Crisis
and
the
Bubble
Burst:

13. Crisis
and
the
Bubble
Burst:
 Mishkin (2007) and Jonas and
Mishkin (2005) state that net
(core) inflation model is
frequently
– more volatile and
– it leads to targets being missed
more than would have been
case with the headline inflation.
 See:
– Mishkin, F: Monetary Policy
Strategy, MIT Press, 2007
– Jonas and Mishkin (2005)
Inflation targeting in Transition
Economies, in Bernanke, B. and
Woodford, M. Inflation targeting
debate, NBER 2005

14. Crisis
and
the
Bubble
Burst:
 Quite few articles show how
contagion of sub-prime MBS
(mortgage based securities)
collapse spread beyond the
borders of US.
e.g.:
 Steven B. Kamin and Laurie
Pounder DeMarco(2010): How Did
a Domestic Housing Slump Turn
into a Global Financial Crisis?;
Federal Reserve System
International Finance Discussion
Papers 2010.
 Brender A and Pisani, F.(2010),
CEPS, Brussels.

15. Why
the
Bubble
Burst:
 Similarly to the 1929 Great
Depression crisis,
 a sudden and sharp monetary
tightening
 with target rate rising 6% in
period form 2004-2006
 most likely triggered the 2007
bubble burst too.
See:
 Bernanke, Ben S. (1983), Non-
Monetary Effects of the Financial
Crisis in the Propagation of the Great
Depression, American Economic
Review,73(3), June 1983, 257-76.
 Bernanke, B. 1995: The
Macroeconomics of Great
Depression, Journal of Money, Credit
and Banking v.27, No. 1 (Feb. 1995)
1-28

16. Why
the
Bubble
Burst:
Debt
accelerator
 I.e., the 2007 bubble burst was
triggered by a combination of
 interest rate increase and
 an un-foreseen accelerating
effect of high debt:
 the unusually high borrowing
 caused by the low rates in the
previous period
 had devastating effect on the
disposable income of the
borrowers once the rates
suddenly rose, and, caused
 a drop of the consumption
demand and
 the resulting drop in GDP
 and bank bankruptcies

17. Why
the
Bubble
Burst:
Debt
accelerator
 E.g. a cash and a interest only
mortgage strapped household,
 with mortgage 30% of
disposable income
 after interest rates doubled,
 could not continue repaying
mortgage which
 now amounted to 60% - 90%
of their disposable income.
 Nor it could spend as usually.
 This dual accelerating effect
then lead to
– collapse of demand
– GDP, and
– bank bankruptcies, further
accelerated by many fixed-
rate mortgages

18. How
the
Bubble
Burst
accelerated:
 than the known mechanisms of
– financial a(de)ccelerator and
– credit rationing
– animal (hurd) instinct
 were also triggered fuelling the
crisis further and,
 CDO & CDS contagion farther.
 Bernanke, B, Gertler, M. and
Gildchrist, S. 1999: The Financial
Accelerator in a Quantitative
Business Cycle Framework, O J.
Taylor and M. Woodford, eds.
Handbook of Macroeconomics,
North Holland, Amsterdam, 2000.
 Stiglitz J.E and Greenwald, B.:
Towards a New Paradigm in
Monetary Economics, CUP 2003

19. Possible
ra.onale
for
keeping
target
rates
low
:
 Keeping wolfs of Japan-like deflation outside gates
 to encourage households’ consumption and growth
 Fed unaware of looming inflation in 2003-4 due to
incomplete real-time data,
 FED using starting to use core rather than the
headline inflation measure,
 Model Insufficiencies
 Distortionary political effect of Presidential elections
in 2004 and 2008

20. Model
Insufficiencies
 Bernanke, B, Gertler, M. and Gildchrist, S. 1999 as many
other authors use standard linarised Euler equation
• ct= -σrt + E(ct+1)
 but it can not capture the time-variant effect of time
variable loans on σ or on E(ct+1) due to RE.
 Also, most commonly used household budget constraint
equations such as Smets and Wouters
 accounts for income but it does not account for the loan
borrowing effect.
 See: Smets, F. and Wouters, .: Shocks and Frictions in US
Business Cycles: A Bayesian DSGE Approach, American
Ecnomic Revieew, 2007. (model in Appendix document)

21. Possible
ra.onale
for
keeping
target
rates
low
:
Distortionary effect of Presidential elections in 2004 and 2008:
 Alesina et al(1992) and find
 “Our results can be summarized as follows: ….
 2) We see some evidence of “political monetary cycles,” that is,
expansionary monetary policy in election years;
 3) We also observe indications of “political budget cycles,” or
“loose” fiscal policy prior to elections;
 4) Inflation exhibits a post-electoral jump, which could be
explained by either the pre-electoral “loose” monetary and fiscal
policies and/or by an opportunistic timing of increases in publicly
controlled prices, or indirect taxes.”
see: - Alesina, A. Cohen G. D., Roubini, N. Macroeconomic Policy and
Elections in OECD Democracies, Economics & Politics Volume 4, Issue
1, pages 130, March 1992
- Frenzese, R.J. : Electoral and Partisan Manipulation of Public Debt in
Developed Democracies, 1956-90, Institute for Social Research, The
University of Michigan working paper, May 1999

22. Conclusions:
 Keeping interest rates low
despite inflation and targeting
rule, and,
 then rising them sharply
contributed to the housing market
 bubble growing and
 its bursting, respectively.
Consequently,
some
form
of
either
 loan
debt/GDP
and/or
 housing
asset
price
bubble
targe4ng
should
be
included
in
 the
stricter
followed
Taylor
rule,
or,
 addi4onal
FM
control
mechanism
 in
a
richer,
more
complex,
mul4ple
(heterogeneous)
agent
models
so
that
bubbles
can
be
contained
and
managed
beNer.

23. Effects
of
infla.on
targe.ng
misfiring
on
development
of
housing
market
bubble
and
its
burs.ng
in
2008
credit
crisis
Author:
George
Perendia,
LMBS
e-­‐mail:
george@perendia.orangehome.co.uk
Thank you for listening!